A covenant is a contractual condition between a lender and a borrower to protect both parties from an unexpected event that could lead to a borrower defaulting on their obligations. Covenants are also legally binding, which means that breaking a covenant could result in a default, financial penalties or forced early repayment.
A typical covenant would require borrowers to comply with certain terms and conditions agreed upon before receiving any funding from lenders. The terms and conditions often include maintaining certain financial ratios, such as the debt-to-equity ratio, maximum debt-to-asset ratio, or interest coverage ratio.
Types of Covenants
The three types of covenants are positive, negative, and financial. Each contains a unique set of requirements and stipulations. Positive and negative covenants are not interchangeable as good or bad but rather refer to what borrowers can or cannot do.
1. Positive Covenants
A positive covenant refers to a promise or contract that requires a party to adhere to certain predefined terms that could encompass compliance aspects, insurance terms, or maintaining a certain credit rating. Affirmative covenants are protective measures for lenders or investors to minimize their risk should any problems arise.
2. Negative Covenants
A negative covenant, usually found in a loan or bond document, is a promise a company makes to not exceed certain financial ratio targets or to not conduct certain activities. A bond covenant prevents certain activities, such as taking on additional debt, or limits the issuer’s ability to make new capital investments.
When an issuer is in violation of a bond covenant, it is considered to be in technical default. A technical default on a bond is simply a failure to uphold a contractual promise it previously made with a lender. A bond issuer that violates a bond covenant often suffers from a downgrade in the bond’s rating, which adversely affects their ability to borrow.
An investor who recently conducted due diligence on Company ABC decides that based on their projections, their $100,000 loan will generate them an annual interest rate of 10%. The investor made the calculations based on the current debt-to-equity ratio and established risk profile.
In a scenario where a restriction from borrowing covenant does not exist, Company ABC would be able to borrow more money from other lenders. The practice increases the company’s risk profile and potentially lowers the returns on the original investors’ money.
The added leverage from the company’s multiple debt obligations makes the investment less attractive. The investor should ideally include set a debt restriction that would prevent Company ABC from taking on additional debt until the current debt is paid off.
3. Financial Covenants
Financial loan covenants are used to measure business performance against the financial projections provided by the management.
Covenants provide more comfort for the lender as they can impose a set of binding rules that ultimately lowers the investor’s exposure to risk. They are usually designed in a way for the lender to get their investment back on their terms, which obviously favors the lender over the borrower. However, covenants are not fool-proof as they cannot ensure that the borrower will not ever default on their obligations.
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